For
20 years the world has tried subsidizing green technology instead of
focusing on making it more efficient. Today Spain spends about 1% of GDP
throwing money at green energy such as solar and wind power. The $11
billion a year is more than Spain spends on higher education.

At
the end of the century, with current commitments, these Spanish efforts
will have delayed the impact of global warming by roughly 61 hours,
according to the estimates of Yale University's well-regarded Dynamic
Integrated Climate-Economy model. Hundreds of billions of dollars for 61
additional hours? That's a bad deal.

Yet when such inefficient
green subsidies are criticized, their defenders can be relied on to
point out that the world subsidizes fossil fuels even more heavily. We
shouldn't subsidize either. But the misinformation surrounding energy
subsidies is considerable, and it helps keep the world from enacting
sensible policy.

Three myths about fossil-fuel subsidies are
worth debunking. The first is the claim, put forth by organizations such
as the Environmental Law Institute, that the U.S. subsidizes fossil
fuels more heavily than green energy. Not so.

The U.S. Energy
Information Administration estimated in 2010 that fossil-fuel subsidies
amounted to $4 billion a year. These include $240 million in credit for
investment in Clean Coal Facilities; a tax deferral worth $980 million
called excess of percentage over cost depletion; and an expense
deduction on amortization of pollution-control equipment. Renewable
sources received more than triple that figure, roughly $14 billion. That
doesn't include $2.5 billion for nuclear energy.

Actual spending
skews even more toward green energy than it seems. Since wind turbines
and other renewable sources produce much less energy than fossil fuels,
the U.S. is paying more for less. Coal-powered electricity is subsidized
at about 5% of one cent for every kilowatt-hour produced, while wind
power gets about a nickel per kwh. For solar power, it costs the
taxpayer 77 cents per kwh.
Critics of fossil-fuel subsidies, such as
climate scientist Jim Hansen, also suggest that the immense size of
global subsidies is evidence of the power over governments wielded by
fossil-fuel companies and climate-change skeptics. Global fossil-fuel
subsidies do exceed those for renewables in raw dollars—$523 billion to
$88 billion, according to the International Energy Agency. But the
disparity is reversed when proportion is taken into account. Fossil
fuels make up more than 80% of global energy, while modern green energy
accounts for about 5%. This means that renewables still receive three
times as much money per energy unit.

But much more important, the
critics ignore that these fossil-fuel subsidies are almost exclusive to
non-Western countries. Twelve such nations account for 75% of the
world's fossil-fuel subsidies. Iran tops the list with $82 billion a
year, followed by Saudi Arabia at $61 billion. Russia, India and China
spend between $30 billion and $40 billion, and Venezuela, Egypt, Iran,
U.A.E., Indonesia, Mexico and Algeria make up the rest.

These
subsidies have nothing to do with cozying up to oil companies or
indulging global-warming skeptics. The spending is a way for governments
to buy political stability: In Venezuela, gas sells at 5.8 cents a
gallon, costing the government $22 billion a year, more than twice what
is spent on health care.

A third myth is propagated by a recent
International Monetary Fund report, "Energy Subsidy Reform—Lessons and
Implications." The organization announced in March that it had
discovered an extra $1.4 trillion in fossil-fuel subsidies that everyone
else overlooked. Of that figure, the report claims, $700 billion comes
from the developed world.

U.S. gasoline and diesel alone make up
about half of the IMF's $700 billion in alleged subsidies. Gasoline and
diesel deserve more taxation, the report says, so the IMF counts taxes
that were not levied as "subsidies." Thus air pollution merits a
34-cents-per-gallon tax, according to the IMF models, while traffic
accidents and congestion should add about $1 per gallon.

According
to the IMF, the U.S. also should have a 17% value-added tax like other
countries, at about 80 cents per gallon. The combined $350 billion such
taxes allegedly would raise gets spun as a subsidy.

The
assumptions behind the IMF's math have some problems. The organization
assumes a social price of carbon dioxide at five times what Europe
currently charges. The air-pollution damages are upward of 10 times
higher than the European Union estimates. And what do traffic accidents
have to do with gasoline subsidies?

Finally, the IMF effectively
ignores the 49.5 cents per gallon in gasoline taxes the U.S. consumer
actually pays. The models cancel out this tax, inexplicably, with an
"international shipping cost." But even if you accept the IMF's
estimated pollution costs and the European-style VAT, the total tax the
IMF says goes uncollected comes to only about 44 cents per gallon—or
less than the actual U.S. tax of 49.5 cents per gallon. The real
under-taxation is zero. The $350 billion is a figment of the IMF's
balance sheet.

Inaccurate information of this sort is needlessly
misinforming public policy. I'm in favor of ending global fossil-fuel
subsidies—and green-energy subsidies. Subsidizing first-generation,
inefficient green energy might make well-off people feel good about
themselves, but it won't transform the energy market.

Green-energy
initiatives must focus on innovations, making new generations of
technology work better and cost less. This will eventually power the
world in a cleaner and cheaper way than fossil fuels. That effort isn't
aided by the perpetuation of myths.

Dr. Lomborg, director of
the Copenhagen Consensus Center, is the author of "How Much Have Global
Problems Cost the World? A Scoreboard from 1900 to 2050" (Cambridge,
2013).

Summary:
We revisit the link between bailouts and bank risk taking. The
expectation of government support to failing banks creates moral
hazard—increases bank risk taking. However, when a bank’s success
depends on both its effort and the overall stability of the banking
system, a government’s commitment to shield banks from contagion may
increase their incentives to invest prudently and so reduce bank risk
taking. This systemic insurance effect will be relatively more important
when bailout rents are low and the risk of contagion (upon a bank
failure) is high. The optimal policy may then be not to try to avoid
bailouts, but to make them “effective”: associated with lower rents.

Excerpts

When
banks expect to be supported in a crisis, they take more risk, because
shareholders, managers, and other stakeholders believe they can shift
negative risk realizations to the taxpayer. So the expectations of
support increase the probability of bank failures that governments want
to avoid in the first place.

This paper highlights that
when there are risks beyond the control of individual banks, such as the
risk of contagion, the expectation of government support, while
creating moral hazard, also entails a virtuous systemic insurance
effect on bank risk taking. The reason is that bailouts protect banks
against contagion, removing an exogenous source of risk, and this may
increase bank incentives to monitor loans. The interaction between the
moral hazard and systemic insurance effects of expected bailouts is the
focus of this paper.

The risk of contagion is one of the reasons that makes banks special. While a car company going bankrupt is an opportunity for its competitors, a bank going bankrupt is a potential threat to the industry, especially when the failing bank is large. Banks are exposed to each other directly through the interbank market, and indirectly through the real economy and nancial markets. While banks have some control over direct exposures, the indirect links are largely beyond an individual banks control. The threat of contagion affects bank incentives. The key mechanism that we consider in this paper is that when a bank can fail due to exogenous circumstances, it does not invest as much to protect itself from idiosyncratic risk. Indeed, would you watch your cholesterol intake while eating on a plane that is likely to crash? Or save money for retirement when living in a war zone? Moreover, making the threat of contagion endogenous to the risk choices of all banks generates a strategic complementarity that ampli es initial results: banks take more risk when other banks take more risk, because risk taking of other banks increases the threat of contagion. [While we focus on the risk that a bank failure imposes on other banks, other papers have focused on the potential bene ts for competing banks that can buy assets of a distressed institution at resale prices, possibly with government support to the buyer.]

Under these circumstances, when the government commits to stem the systemic effects of bank failure, it has two effects on bank incentives. The rst is the classical moral hazard effect described in much of the literature. The second is a systemic insurance effect that increases banksincentives to monitor loans (this is similar to the effect identi ed for macro shocks by Cordella and Levy-Yeyati, 2003, and to that of IMF lending to sovereigns in Corsetti et al., 2006). The promise of bailout removes a risk outside the control of a bank and increases its return to monitoring. Going back to our risky ight parable, how would your choice of meal change if you had a parachute?

Formally, we develop a model of financial intermediation where banks use deposits (or debt) and their own capital to fund a portfolio of risky loans. The bank portfolio is subject to two sources of risk. The fi rst is idiosyncratic and under the control of the bank. Think about this risk as dependent on the quality of a banks borrowers, which the bank can control through costly monitoring or screening. The second source of risk is contagion. Think about this, for example, as a form of macro risk. When a bank of systemic importance fails, it has negative effects on the real economy, possibly triggering a recession. A deep enough recession can lead even the best borrowers into trouble and, as a consequence, can cause the failure of other banks independently of the quality of their own portfolio. The risk of contagion is exogenous to individual banks (it cannot be managed or diversi ed), but it is endogenous to the nancial system as a whole, since it depends on risk taking by all banks.

These two sources of risk are associated to two inefficiencies. First, banks are protected by limited liability and informational asymmetries prevent investors from pricing risk at the margin. As a result, in equilibrium banks will take excessive idiosyncratic risk. As in other models, this problem can be ameliorated through capital requirements. The second ine¢ ciency stems from externalities. When individual banks do not take into account the effect of their risk taking on other banks, they take too much risk relative to the coordinated solution. And since banks are also affected by the externality, this exogenous source of risk reduces the private return to portfolio monitoring/screening. Bank increase idiosyncratic risk, increasing also the contagion externality. Capital requirements cannot fully correct this problem: even a bank fully funded by capital will take excessive risk when exposed to risk externalities.

Against this background, government intervention in support of failing banks has two opposite effects on incentives. It exacerbates the moral hazard problem stemming from limited liability, but reduces the externality problem associated with contagion. The extent of moral hazard depends on the rents that the government leaves to bailed out banks, while the importance of the "systemic insurance" effect depends on the probability of contagion. Thus, there are parameter values .low bailout rents and a high risk of contagion -- for which the promise of government intervention leads to lower bank risk and better ex ante outcomes.

The "systemic insurance" effects continue to be present when we allow banks to correlate their investments. The threat of contagion may induce banks to excessively correlate their portfolios, because contagion discourages strategies that pay off when other banks fail. Such correlation may be undesirable for a number of reasons .ine¢ cient distribution of credit in the economy, lower bank profits, or an increased probability of simultaneous bank failures (which are socially costly; Acharya, 2009). We show that the expectations of government support may reduce banks'incentives to correlate their investments by decreasing the risk of contagion. It is important to interpret our results with caution. First, they should not be seen as downplaying the moral hazard implications of bailouts. Rather, we argue that such implications have to be balanced with systemic insurance effects. Systemic insurance may be important for some, but not all parameter values. The best illustration for the case where systemic insurance effects might dominate would be a financial system on the brink of the crisis (with weak banks and high probability of contagion) with well-designed bank resolution rules (which minimize bailout rents). Second, we focus on ex ante effects of policies. Ex post considerations may be different and depend e.g. on the difference between the economic costs of bank bankruptcy and that of the use of public funds. Third, and most critically, we assume that the government is able to commit to a given bailout strategy. In a richer model with potential time inconsistencies in the government reaction function, outcomes may be more complex. In particular, banks may find it optimal to take correlated risks if they believe that bailouts will be more likely when many of them fail simultaneously.

Several recent papers have explored the effects of expected government support on bank risk taking. In these papers, bailouts increase risk taking and generate a strategic complementarity among banks when the probability of bailouts increases with the share of the banking system that is in distress. We add to that literature by introducing a risk externality in the form of an undiversi able contagion risk. This risk externality creates an additional strategic complementarity in risk taking, one that does not result from government policy. In contrast to the existing literature, by preventing contagion, bailouts can reduce the strategic externalities and bank risk taking. The paper relates to the literature on government intervention as a means of preventing contagion. The observation that by removing exogenous risk the government can improve banks monitoring incentives was first made by Cordella and Levy-Yeyati (2003), in the context of macroeconomic shocks. Our model builds on their work by making these shocks endogenous to the banking system, thus offering a link between individual bank risk taking and systemic risk. [Orszag and Stiglitz (2002) use the creation of fire departments as a parable to describe how risk taking incentives are affected by externalities and public policy. In their model (like here), individuals do not take into account the effects of reproof houses on reducing the risk of fire damage to their neighborshomes, and invest too little in fire safety. The introduction of a fire department reduces the risk of a fire, but further worsens individual incentives, as it reduces the probability that a fire spreads from one house to another. To extend their parable, our paper is more about condo buildings rather than single-family houses. If the rest of the building burns down and collapses, a condo owner gets little benefit from having reproofed her own apartment. Then, the introduction of a fire department makes individual safety measures more valuable as it reduces the probability of total meltdown.]